Definition
Fiscal policy is the deliberate use of government spending and taxation to influence economic conditions — aggregate demand, employment, inflation, and long-run growth. Unlike monetary policy, which is conducted by an independent central bank, fiscal policy is made by elected legislatures and executives, and thus is subject to political constraints, legislative lags, and distributional conflicts that monetary policy avoids.
Fiscal policy has two instruments: the spending side (buying goods and services, transfers to households, subsidies) and the revenue side (income taxes, corporate taxes, sales taxes, tariffs). Expanding spending or cutting taxes is "expansionary" — it adds to aggregate demand. Cutting spending or raising taxes is "contractionary" — it reduces aggregate demand.
Why it matters
Expansionary vs. contractionary fiscal policy
The deficit and debt trade-off
Running deficits to stabilize
Keynesian economics prescribes deficit spending in recessions (when private demand collapses, the government borrows and spends to fill the gap) and surpluses in booms (pay down debt while the economy can afford reduced government support). In practice, political incentives produce deficits in both phases — politicians find it easy to cut taxes or spend in good times, harder to raise taxes or cut spending in bad times.
When does debt become a problem?
Government debt is not inherently destabilizing. A country that borrows in its own currency and whose debt grows slower than the economy (debt/GDP ratio stable or falling) is on a sustainable path. Problems emerge when: interest costs consume a growing share of the budget; investor confidence falls and borrowing rates spike; or the debt load is so high that the government lacks "fiscal space" to respond to the next recession.
Automatic stabilizers vs. discretionary policy
Automatic stabilizers
Some fiscal policies are "automatic" — they respond to economic conditions without legislative action. Unemployment insurance payments rise automatically when unemployment rises (adding to aggregate demand when it's most needed). Progressive income taxes automatically collect less revenue in recessions (lower incomes → lower tax bills), leaving more disposable income with households. These built-in stabilizers reduce the volatility of the business cycle without the political and timing problems of discretionary action.
Discretionary policy
Discretionary fiscal policy — a stimulus package, a tax cut, an austerity budget — requires legislative action, which takes time. The inside lag (recognizing the problem and passing legislation) typically runs 6–18 months, by which time economic conditions may have changed. Combined with the outside lag (the time for spending to affect the economy), discretionary fiscal policy often arrives late — sometimes amplifying the next phase of the cycle rather than dampening the current one.